5.(5) liquidity risk

8/14/2019 5.(5) Liquidity Risk

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5. Key Risk Managemen Issues(5) Liquidity Risk

Sakamaki Tsuzuri

JICA Chief Advisor to the State Bank of Vietnam

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The L iqu idi ty Coverage Ratio

This Basel proposal focuses on asset liquidityto ensure banks always have a 30-dayliquidity cover for emergency situations. TheBasel Committee is proposing a LiquidityCoverage Ratio (LCR) defined as:

LCR= (High Quality Assets)/(30 Day Net cashOutflows) 100%

where the value of assets and the outflowsrefer to those that would arise with a majorfinancial shock, a deposit run-off and a 3-notch downgrade in the credit rating.

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High-quality assets can include those witha low correlation to risky assets, listed in

active stable markets, with market makers

and low concentration of buyers and

sellers; i.e. easily convertible to cash in

stressed markets (e.g. cash, central bank

reserves, marketable claims on sovereigns,

central banks, the BIS, IMF etc., andgovernment debt issued in the currency of

the country of operation).

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Corporate and covered bonds may beeligibleafter a quantitative impactstudywith an appropriate haircut.

Cash outflows will be based on themodeling of funding run-offs: stable

and less stable deposits; unsecured

wholesale funding; and secured(collateralized) funding run-off.

Further clarifications are: (as follows)

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Derivatives pose a problem asdowngrades require collateral to bepostedi.e. additional liquidity

requirements. The Basel Committee proposes that, if

collateral in the form of cash or high-quality debt is already posted, then no

additional LCR is required. But if other collateral is used, a 20%

collateral surcharge will apply.

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For credit facilities extended, bankswill need to hold 10% of the drawdownin the shock scenario for retail and

non-financial corporate customers. For liquidity facilities to non-financial

corporates, 100% of the amount isrequired, and similarly for other

entities like banks, securities firms,insurance companies, SPVs,sovereigns, central banks etc.

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On the cash inflow side, supervisorsand banks need to ensure no

concentration or dependence on a few

sources. No credit facilities extended to the

bank can be included as inflow.

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The Net Stab le Fund ing Ratio

To ensure stable funding over a one-year horizon, the Basel Committee is

proposing that the liquidity

characteristics of banks asset andliability matching structure be

controlled through the Net Stable

Funding Ratio (NSFR):NSFR= (Available Stable Funding

$)/(Required Stable Funding) 100%

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Available Stable Funding is definedas:

Tier 1 and Tier 2 capital (100%)

+ preferred stock not in Tier 2 withmaturity 1 year (100%)

+ liabilities1year (100%)

+ stable shorter-term retail & small

business funding (with 1m percustomer) (85%)

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+ less stable (e.g. uninsured non-maturity) retail & small business

funding (70%)

+ unsecured wholesale funding(50%).

Central bank discounting is excluded

to avoid overreliance on central banks.

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The Required Stable Funding (RSF) isbased on balance-sheet and off-

balance-sheet exposures, and is

defined as:Cash, securities 1year, loans to

financial firms 1year (0%)

+ unencumbered marketablesovereign, central bank, BIS, IMF etc

AA or higher with a 0% risk weight

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+ Gold, listed equities, corporatebonds AA- to A- 1year, loans tononfinancial corporate 1year (50%)

+ loans to retail clients (85%)+ all else (100%).

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Off-balance-sheet exposures to beincluded are conditionally revocable &

irrevocable credit facilities to persons,

firms, SPVs and public sector entities:a 10% RSF of the currently undrawn

portion.

All other obligations will have an RSFset by the national supervisor.

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Other mon i tor ing

The Basel Committee is also proposingto monitor key variables of concernrequiring disclosure to supervisors:

Contractual maturity mismatch onall on- and off-balance-sheet flowsmapped to various time framesdaily,weekly, monthly, etc. (e.g., overnight, 7

day, 14 day, 1, 2, 3 and 6 months, and1, 3, 5 and beyond 5 years) Bankshave to explain how any mismatchesare going to be bridged.

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Concentrationof funding over differenttime horizons (less than one month, 1-to-3

months, 3-to-6 months, 6-to-12 months,

and for longer than 12 months):

(a) (Funding liability from significant

counterparties)/(Balance sheet total)

(b) (Funding liability from each significant

product)/(Balance sheet total)(c) List of assets and liabilities by

significant currency.

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A significant counterparty, product orcurrency means 1% of the bankstotal liabilities.

These will provide a basis fordiscussion with supervisors and

possible action.

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Available unencumbered assetswhich are marketable as collateral in

secondary markets and/or are

eligible for central bank standingfacilities will need to be disclosed by

significant currency.

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Market-Related Monitoring Tools relates toearly warning indicators in monitoringpotential liquidity difficulties at banks.

They include market-wide information (forexample, equity prices and spreads in debtmarkets generally), information on thefinancial sector (for example, equity and debtmarket information for the financial sectorbroadly and for specific subsets of the

financial sector, including indices), and bank-specific information (for example, informationon the equity prices of the specific bank orcredit default swaps spreads for the bank).

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Quantitative Frameworks for

Liquidity Risk Measurement

To assess liquidity riskquantitatively, banks apply threetypes of analysis:

(1) balance sheet liquidity analysis

(2) cash capital analysis

(3) maturity mismatch analysis


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Whereas a balance sheet liquidityanalysisrequires only the evaluation ofliquidity of different balance sheet items,the maturity mismatch approachusesquite an amount of modeling andbehavioral adjustments.

Thus the degree of sophistication and,hopefully, the degree of accuracy increase

when going from the balance sheetliquidity analysis to the maturitymismatch approach.


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Balance Sheet Liquidity Analysis

The balance sheet liquidityapproach sets different balancesheet items on the asset side andthe liability side into relation,depending on whether assets areliquidor illiquid, and on whether

their funding is stable(sticky) orvolatile.


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To secure an appropriate balance sheetstructure with respect to liquidity risk,stickyassets should be funded by stableliabilities, and liquid assets can befunded by volatileliabilities.

The following exhibit shows balance sheetitems that are relevant for a liquidityanalysis.

Not included are intangibles, strategicinvestments and equity capital, which arenot at disposal for liquidation.


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Exhibit Balance sheet liquidity analysis for two exemplary banks

Liquefiable assets (US$) Bank A Bank B

Loans and receivables, investments, and others 50 100

Trading assets 30 10

Reverse repos 30 0

Liquefiable liabilities (US$) Bank A Bank B

Non-bank deposits 20 70

Certified liabilities 20 10

Equity 10 10

Unsecured bank deposits/others 20 15

Trading liabilities 30 5

Repos 10 0


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Bank A is a large bank with a strongsecurity business and strongdependence on interbank andcapital markets funding.

Bank B is a small bank which holdssecurities only as stand-by liquidity

and relies mainly on deposit funding.


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One would imagine that Bank A,working in the volatile business ofcapital markets, has much more

liquidity risk in its balance sheetthan Bank B doing classical retailbanking.

However, from the pure balance

sheet structure the analysis revealsa different picture.


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Bank A has $50 of sticky assets in loansand receivables that perfectly match with$20 of stable funding from non-bankdeposits, $20 of stable funding fromcertified liabilities, and $10 of equity.

For Bank B the picture looks worse: thereare $100 of sticky assets in loans andreceivables that do not match with $70 of

stable funding from non-bank deposits,$10 of stable funding from certifiedliabilities, and $10 of equity.


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Analysis of liquid assets with volatilefunding gives the same result:

Bank As volatile liabilities in $20 ofunsecured bank deposits, $30 of trading

liabilities, and $10 of repos are coveredby $30 of trading assets and $30 ofreverse repos.

Again Bank B looks worse: there are $15in unsecured bank deposits and $5 in

trading liabilities that are not covered bythe stand-by liquidity of $10 in tradingassets.


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There are a few problems with thisanalysis.

(1) Missing time dimension

(2) Impact of accounting rules

(3) Off-balance sheet commitments

(4) Marketability of securities

(5) Commercial papers

(6) Non-bank deposits


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Cash Capital Position

Moodys originally invented the cashcapital concept to analyze the liquiditystructure of a banks balance sheet aspart of its external rating process.

Its intention is to measure the banksability to fund its assets on a fullycollateralized basisassuming that theaccess to unsecured funding has been lost.

For example, such scenario can occurafter the downgrade of a banks (short-term) rating.


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Cash capital is the gap between thecollateral value of unencumbered assets,and the volume of short-term inter-bankfunding and non-core parts of non-bankdeposits.

Stated differently, cash capital is definedas the aggregate of long-term debt, coredeposits and equity (and contingency

funding capacities) minus firm-widehaircuts, contingent outflows and illiquidassets.


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Unencumbered assetsare defined asassets that are available to be used ascollateral.

Usually, unencumbered assets are

calculated as the market value of the netsecurity position after accounting forbond/equity financing transactions:

Unencumbered securities = longsecuritiesshort securities position +

reverse repod securitiesrepodsecurities + borrowed securities lentsecurities.


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The collateral value is thendetermined by subtracting haircutsfrom the current market value of

the unencumbered securities. These haircuts account for the

marketability of the securities.

Haircuts used by Moodys and forsecurities firms are given in thefollowing exhibit.


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Exhibit Examples of haircuts for marketability of securities fromMoodys and for securities firms

Asset class Moodys Securities firms

Government bonds 2% 5%Highly liquid mortgage-backedsecurities

2% 10%

Prime CPs and bank acceptances 10% 5%

Listed equities 15% 30%

Bank debt 33% 15%

Corporate debt 33% 20%

Money market instruments 2% 5%


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It is important to note that borrowedsecuritiescan be counted asunencumbered securities in the cashcapital framework.

The reason is that they can be used ascollateral; for instance, in a repotransaction.

However, in the mismatch framework

discussed below, they only provideliquidity for the time window between theborrowing and returning of them.


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Maturity Mismatch Approach

In a quantitative approach tomeasuring liquidity risk, the netcumulative cash outflows (NCO)and the unencumbered assets(tocover the NCO) must be estimatedper time period and under different

scenarios.


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For this purpose liquidation cashflows from all liquefiable balancesheet and off-balance sheet items

are mapped to a maturity ladder. There are four categories to be

distinguished, depending onwhether the amountand the

timingof cash flows aredeterministic or stochastic:


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Category I: Cash flow amount andcash flow timing are deterministic.Examples are: Coupon andamortization payments of fixed-rateloans and fixed-rate bonds, cashflows from secured and unsecured

money markets funds, and termdeposits.


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Category III: Cash flow amountdeterministic and cash flow timingis stochastic. Examples are:repayments of callable bonds,repayment of loans with flexibleamortization schedule, travelers

checks.


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Category IV: Cash flow amount andcash flow timing are stochastic.Examples are: sight (demand) and

saving deposits, drawdowns oncommitted credit lines and revolvingloans, collateral value of marketable

assets (bonds, stock, funds), andsettlement payments of Americanoptions.


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Whereas the cash flow mapping ofCategory I assets is fairly straightforward it only requires proper

data infrastructure that provides thecorrect balance sheet positionCategory II-IVassets requireadditional model assumptions and

behavioral adjustments independence of the scenario underconsideration.


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The net cumulative inflows comprise cashflows from:

the cash positionmodeled as inflow in

the overnight time bucket. Alternatively,one may consider it as working capitaland not count it as an inflow at all.

Committed backup linesat other banks

modeled as inflow in the overnight timebucket (Access to this source of funds isextremely scenario dependent.)


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Unencumbered securitiesmodeledaccording to a liquidation scenariodepending on the credit quality,central bank and collateral marketseligibility, daily turnover, and marketdepth of each security. Liquid bondstypically generate short-term liquidityinflow irrespective of their interest

rate risk duration or maturity. Thematurity of a bond is only relevant inthat aspect as the liquidation periodcannot be longer than the finalmaturity of the bond.


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The net cumulative outflowcomprisescash inflows and outflows from:

Loans (coupon and notional) modeled

according to the coupon and amortizationschedule

Non-bank (retail) deposits modeledaccording to a core level model

Deposits from banks, corporations andgovernments, as well as CDs, modeledaccording to residual maturity


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Own capital market funds (issuedbonds and private placements)modeled according to residual

maturity Off-balance sheet commitment in

revolving loans, committed creditlines, and other off-balance sheet

items modeled as short-termoutflow.


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new loans / funding rollover

One should emphasize that includingongoing new loan business also requires acertain assumption on a rollover rate forfunding.

Although this is certainly valid in a goingconcern scenario, it will add furtherassumption on the cash flow modelingside.

According to this, most banks only

consider a pure run-off gap profilewithout new loan and rolled over fundingtransactions.


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equity and participations

Not shown in the gap profile are equitycapital on the liability side and strategicinvestments (participations) on the assetside.

Both positions are not at the disposal of aTreasurers daily liquidity managementprocess, but require the strategic decisionof the Board.

Knowing the investment horizon of

participations, equity capital could bemodeled congruently in a rolling portfolioapproach.


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The cumulative sum comprises thenet cumulative outflows, which isthe liquidity risk measure analogous

to VaRbeing the risk measure formarket, credit or operational risks.

Subtracting the net cumulative

outflows from the net cumulativeinflows provides the net cumulativeliquidity gapper time bucket.


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A positive net cumulative gap indicatesthat the bank can cover all its outflows byliquidating its unencumbered assets.

A negative gap does not necessarily mean

that the bank is insolvent. It only indicates that the liquidation of its

inventory will not be sufficient to cover itsoutflows with respect to todays balancesheet positions; that is, without any

rollover of funding and new assets, andwith respect to the scenario assumed forthe cash flow modeling.


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Long Term Funding Ratio

The last box in the previous exhibitshows the long-term assets and theavailable term funding above one,

three, six and 10 years. The funding ratiois defined as:

Funding ratio above n years = (sumof available funding above n

years)/(sum of assets maturingabove n years).


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The position in long-term assetsusually consists of loans.

Long-term funding is composed ofissued bonds and core deposits.

A funding ratio is a key figure toobserve the structural liquidity

riskin a banks balance sheet.


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In contrast to the interest rate riskpositioning of the balance sheet, whichcanthanks to a liquid interest-rateswap marketeasily be changed onshort notice, deficiencies in the liquidityrisk structure in the balance sheetcannot easily be fixed.

Management of liquidity risk requires a

long-term horizon. The funding ratiois a useful tool to

monitor the long-term funding structure.


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scenarios

A liquidity gap analysisis usuallydone under different scenarios.

Liquidity

Sc

enarios

normal operating scenario

general market disruptionscenario

national macroeconomic disruption scenario

banking industry-wide disruption scenario

bank-specificcrisis scenario

downgrade scenario

loss of a big investor scenario

bank run scenario, and so on


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Similarly, in the market disruptionscenario, backup lines of creditmayhave to be funded, but in the normal

operating liquidity scenario, backup linesare unlikely to be drawn upon.

Generally, inflows in the liquidity gapprofile will be shifted to later time buckets

and outflows to earlier time buckets.


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Some banks also include new assetsand/or rollovers of fundingin their gapanalysis.

In this case the net cumulative gap mustalways be positive.

Although such an analysis is morerealistic, it requires even moreassumptions concerning future cash flows.

For other banks this is the reason to stayaway from such a setting and to use apure run-off profile.

5.(5) liquidity risk

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